No two investors are alike. If you’ve been a financial advisor for a while, you’ve likely seen a wide range of individuals whose hopes, dreams, fears, and circumstances influence their investing approach.
To guide each client appropriately, you need to understand their feelings and attitudes toward risk. A client who’s comfortable riding out the highs and lows of the market will not have the same portfolio as one who’s risk-averse. You can only match clients with the right investment strategy when you understand where they fall on the risk spectrum.
A risk tolerance questionnaire is the tool advisors traditionally use to quantify a client’s risk. But having your client complete an assessment is only half of the equation. The real work begins when you use the evaluation to determine your client’s risk persona and craft a financial plan that suits their unique needs.
Let’s take a closer look at risk assessments and personas: how they quantify risk, how to understand where your client falls on the risk spectrum, and how risk analytics software can help you meet each client where they are on that continuum.
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The Value of an Assessment to Quantify Risk
One of the most significant challenges advisors face in helping clients navigate risk is that clients may be unaware of their own risk appetite or tolerance.
A client may say they’re a fearless investor, but when faced with a precipitous drop in value on a particularly dark day in the markets, they may call you in a panic asking to sell all their equity holdings.
Conversely, a client who says they’re nervous and only wants to hold the lowest-risk financial instruments may be disappointed when the S&P skyrockets and they see only a modest uptick in returns.
A risk assessment gives you and your client a framework for understanding and quantifying risk. It puts you both on the same page and helps you to have more productive conversations about finding a balance between serving their long-term goals and addressing their risk-minded concerns.
It also helps you to draw a line between risk tolerance levels and risk appetite. While a client’s risk appetite is where they fall on the spectrum of risk — somewhere between very conservative to very aggressive — risk tolerance is how much they’re willing to deviate from that anchor point. For example, some very aggressive investors are comfortable withstanding, say, a 50% loss in portfolio value, while others may tap out at a 45% drop.
Risk in Three Dimensions
To generate a comprehensive picture of risk tolerance vs. risk appetite, you must assess risk on several dimensions. As you can see, the concepts of risk tolerance and risk appetite lend heft to your discussions about risk. A three-dimensional assessment is necessary to understand the full texture of a client’s attitudes toward risk.
A 3D risk profile assesses risk on the following levels:
- Risk Capacity: How do concrete factors like age, income, current net worth, and financial understanding impact an investor’s ability to take on risk?
- Risk Tolerance: How willing is the investor to accept increased risk for the potential of a greater upside?
- Risk Composure: How is the investor expected to behave during market elation or stress?
Once you’ve evaluated a client’s feelings around risk, you can place them on a spectrum according to their risk appetite.
Those clients who are most willing and able to withstand wild ups and downs will be on the furthest end of the aggressive side of the spectrum. Clients who are most fearful and have the shortest investing time horizon will be on the other side, among your most conservative investors. Individuals who fall in the middle are considered moderate.
How do these risk personas play out in reality, and how can you help each kind of investor find the best path forward to achieve their goals? Let’s explore these questions by reviewing hypothetical examples of each risk persona type.
Risk Tolerance Persona 1: Conservative Corey
Investors are considered conservative when they have feelings, attitudes, and attributes that make them highly risk-averse. Let’s take Corey as a hypothetical example. Here’s the story behind Corey’s risk persona.
Risk Capacity: Corey is a baby boomer who is enjoying his retirement years. By virtue of his age, Corey’s time horizon is shorter than a younger investor’s. If the market hits a major snag this year, he doesn’t have 20 years to recoup his losses — he needs access to at least some of that money in the short term.
Risk Tolerance: Corey has some money in retirement accounts, and he’d like to generate some more income from those investments, but he’s nervous about assuming too much risk and losing the retirement savings he needs to live.
Risk Composure: Because he’s on a fixed income, Corey gets very concerned when he sees the headlines about inflation or a potential recession. He is often on the phone with your office when a news item breaks, reiterating his worry about the damage a downturn could do to his portfolio.
For a conservative investor like Corey, your primary job is to calm his worries, then take steps to insulate him from hypothetical downside risk while maximizing his upside potential.
Risk Tolerance Persona 2: Moderate Madison
Moderate investors, as their name indicates, are middle-of-the-road in their risk score. While they’re not ready to bet it all on Dogecoin, they’re also looking to generate returns and are willing to accept some of the risks that come with it.
Madison, a woman in her mid-thirties, is an example of a client with moderate risk tolerance. Here’s where she falls regarding capacity, tolerance, and composure.
Risk Capacity: Madison is in her prime earning years and has about three decades to go before she hits retirement. She has plenty more time to enjoy the power of compounding, and she’s a well-educated investor who has her money spread out between tax-advantaged retirement plans plus, a brokerage account for funds to support her shorter-term goals.
Risk Tolerance: As a savvy investor, Madison is comfortable with the ups and downs of the market. She knows there’s value in staying the course and doesn’t get easily flustered. However, the idea of watching her accounts lose half their value makes her skittish.
Risk Composure: Madison is relatively calm during times of volatility, but she is conscious of some significant expenditures coming up in the following years and decades — she plans to become a parent in the next few years, and she dreams of gut renovating her kitchen. She is conscious of taking on unnecessary risk in her brokerage account, which she intends to use for some of these shorter-term expenditures.
For Madison, you’ll aim to strike the right balance between aggression and sensibility. And because her life circumstances are in flux, she’s the type of client to check in with regularly so you can reassess her goals and risk profile.
Risk Tolerance Persona 3: Aggressive Adrian
Investors with an aggressive risk tolerance persona are not afraid of anything. These investors understand that great risk can generate significant upside, and they have life circumstances that allow them to accept sky-high levels of risk.
Let’s call our aggressive investor persona Adrian. Here’s why he’s so brash in his approach to investing.
Risk Capacity: Adrian is a young person in his 20s who enjoys a successful career in management consulting, leaving him with additional money to invest. He soaks up financial education like a sponge, spending time on #FinTok and some crypto Discord channels.
Risk Tolerance: Adrian rents in a major city and doesn’t have a spouse or children. Without some of the financial responsibilities that often come a bit later in life, he’s willing to swing big on riskier investments.
Risk Composure: Adrian has fully adopted the “HODL” mentality popular among crypto enthusiasts. He doesn’t bat an eye when his speculative assets plummet in value. He’s ready and willing to ride the waves all the way down in hopes that they’ll go all the way up someday.
With an investor like Adrian, education and behavioral coaching will likely be part of your advisory work. As a fiduciary,you must help these gutsy investors act in their own best interest. You have the opportunity to show them the value of diversification and help them find an investing strategy that still generates significant upside without taking unnecessary risks.
How To Support Different Risk Personas with Risk Analytics Software
While Adrian, Madison, and Corey represent distinct points on the risk appetite spectrum, your clients likely won’t fit so neatly into one of these three categories. Instead, real investors fall at various points across the risk spectrum, and it’s your job to meet each one where they are with solutions that suit their individual standing.
Risk analytics software can help you achieve tailored investment recommendations that help your client reach their goals and help you deliver on your fiduciary duty.
It starts with creating a unified risk methodology. Risk analytics software can help codify the process of scoring, assessing, and defining risk so that your entire firm is aligned in its approach. This enhances your ability to meet your fiduciary responsibility and ensures consistency in your client relationships across advisors.
Next, risk analytics software allows your advisors to access a model marketplace, where they can peruse the full range of options in your model library — from Advisor as PM to third-party offerings. Risk analytics tools help advisors identify the models that align with their client’s risk score, and many allow advisors to blend or adjust models to achieve their target level of risk.
Stress testing helps advisors to try their strategy before finalizing anything. Run your proposed approach through a handful of relevant stress-testing scenarios to gain insights into hypothetical upside and downside risk. Does the proposed approach still align with your client’s risk tolerance in a macro crisis? If the downside is too steep, you can adjust your models and retest until you’re happy with the hypothetical range of risk on either side.
And, of course, these risk analytics tools don’t just support your behind-the-scenes work — they also play a critical role in client education and behavioral coaching.
When Conservative Corey calls you in a panic about the latest economic headline related to the Fed rate hikes, you run his portfolio through your “Fed Shock Therapy” stress-testing scenario and show him how your strategy has sought to insulate him from hypothetical downside in a bad scenario.
When Aggressive Adrian reaches out, saying he’d like to move the bulk of his investments into the latest meme stock, you can show him a side-by-side comparison of how a well-balanced portfolio may behave in times of hypothetical macro stress versus how a portfolio that’s overweighted in speculative assets could react.
Finally, risk analytics software helps you to adjust your strategy as your client’s risk appetite and tolerance shift. When Moderate Madison has her baby and wants to start saving for their college education, you can help her find a strategy that aligns with her risk score.
Regardless of where your client falls on the risk spectrum, your job as their advisor is to meet them with a strategy that fits their risk tolerance and supports their big goals. Embracing a risk analytics software solution can help you understand your client’s risk persona and create a plan to suit their reality.
Access to the services presented is provided solely as a service to financial advisors. Orion Risk Intelligence does not make recommendations or determine the suitability of any security or strategy. Past performance of a security or strategy does not guarantee future results. Orion Risk Intelligence research and tools are provided for informational purposes only. While the information is deemed reliable, Orion Risk Intelligence does not guarantee its accuracy, completeness, or suitability for any purpose, and makes no warranties with respect to the results to be obtained from its use.
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